DEMAND FOR MONEY

VARIOUS APPROACHES TO DEMAND

FOR MONEY
FISHER’S TRANSACTION APPROACH TO
THE QUANTITY THEORY OF MONEY
CASH TRANSACTION EQUATION
 Fisher’s equation of exchange,
 MV= PT
M= Quantity of money in circulation
V= transactions velocity of circulation of money
P= Average price of all kinds of market
transactions
T= total no. of transactions
ASSUMPTIONS
OBSERVATIONS
P = MV/T

 Given V and T, changes in M lead to changes in

P
 Changes in M lead to equiproportionate changes
in P
THE QUANTITY THEORY: THE INCOME
VERSION
 Quantity equation expressed in terms of real income
 y= Y/P; y= real national income, Y= nominal national
income, P=price level
 Therefore, Y= Py

 The income version of quantity theory can be expressed

as:

 MV=Py
DEMAND FOR MONEY
 Demand for money in an economy is determined by the
value of transactions.

 MV=PT
 M= 1/V. PT

 At equilibrium, Ms= Md

 Md= kPT (k=1/V)

CAMBRIDGE CASH BALANCE
APPROACH
 Cambridge Cash-Balance theory of demand for money
was given by Cambridge economists- Marshall, Pigou
 Emphasis on function of money as a “store of value”
instead of Fisher’s emphasis on use of money as a
“medium of exchange”
 Demand for money is the amount of money people want
or desire to hold
CASH BALANCE VERSION
 Md=KY
where, Md= amount of money demanded
Y= national income in money terms
P= average price level of currently produced goods
and services
K= a constant

K depicts the proportion of money income, which the public

likes to hold as money
We know,
y=Y/P
Therefore, Y=Py
CASH BALANCE VERSION

Md=KPy
KEYNES THEORY OF DEMAND FOR
MONEY
 Liquidity preference means the demand for
money to hold or the desire of the public to hold
cash
 Emphasis on store of value function of money

 The desire for liquidity arises because of 3

motives:
 The transactions motive
 The precautionary motive
 The speculative motive
THE TRANSACTIONS DEMAND FOR
MONEY
THE TRANSACTIONS DEMAND FOR
MONEY
 Why the money is held is due to the time gap involved
between which the income is received and the payments
are made out

 Closer the gap, smaller the transactions demand for

money
THE TRANSACTIONS DEMAND FOR
MONEY
TRANSACTIONS DEMAND AS A
FUNCTION OF INCOME
 Stable and direct relationship between income and
transactions money balances

 Mt= kY or Mt= kPy

 Mt= amount of money balances demanded for

transactions
 k= fraction of money income which the public likes to
hold as money balances for transactions
 Y= income level
 Mt= kPy
 Mt/P= k(y)

 Or mt= k(y)

 mt= amount of real balances for transactions

 K= ¼
 Y= 4000

 mt= ?

 If k= 1/5
 Y= 4000

 mt= ?
 K= ¼
 Y= 4000

 mt= 1000

 If k= 1/5
 Y= 4000

 mt= 800
TRANSACTIONS DEMAND AS A
FUNCTION OF RATE OF INTEREST
 Perfectly interest inelastic
PRECAUTIONARY DEMAND FOR
MONEY
SPECULATIVE DEMAND FOR MONEY
BOND PRICING CONCEPTS
INTEREST RATE AND BOND PRICES
 A rise in the market rate of interest implies decrease in
the price of bond and vice versa

 Inverse relationship between the market rates of interest

and price of a bond
SPECULATORS
 Bulls
 Bears
CONCLUSIONS
LIQUIDITY TRAP
 Speculative demand curve for money depicts an inverse
relationship between interest rate and speculative
demand for money
LIQUIDITY TRAP
 At a high rate of interest, there is very little demand for
speculative money
 As the interest rate moves lower and lower, the demand
for speculative balances becomes larger and larger until
it reaches X where it becomes infinitely elastic
 i.e. any increase in money supply will be held as cash
balances
 This is known as liquidity trap
SPECULATIVE DEMAND FOR MONEY AS
A FUNCTION OF RATE OF INTEREST
 Msp= Pg (r ) ----- in nominal terms
 Where, Msp= amount of money balances held for
speculative purposes
 P= price level

 r= rate of interest

 Msp/P= Pg (r )/P ----- in real terms

 Hence msp = g (r )

 Where msp = amount of real balances held for speculative

purposes
TOTAL DEMAND FOR MONEY
 md= mt +msp

 md= total demand for money

 mt = transactions demand for money
 Msp = speculative demand for money

 mt = k (Y)
 msp = g (r )
 Therefore,

 md= k (Y) + g (r )
CRITICISM
 In reality individuals hold a diversified portfolio
 A variety of financial assets have different characteristics

 Keynes division of money into transaction,

precautionary and speculative motive is not realistic
 Many economists had emphasized that transactions
demand is interest elastic
KEYNES’ THEORY OF INTEREST
 The rate of interest is a purely monetary phenomenon
 It is determined by demand for money and supply of
money.
 According to him ”interest is a reward for parting with
liquidity for a specified period.”
THE KEYNESIAN THEORY:
DETERMINATION OF RATE OF
INTEREST
 md= k (Y) + g (r )

 Keynes assumed that supply of money is exogenously

determined by monetary authorities
 In nominal terms,

 Md=Ms
 md=ms
 k (Y) + g (r ) = ms
VARIATIONS IN THE INTEREST RATE
 Changes in the supply of money and their effects on
interest rate
Rate of Interest (r)

ms1 ms2 ms3 ms4

r2

r1
r0 md

m
CHANGES IN THE TRANSACTIONS DEMAND
FOR MONEY AND THEIR EFFECTS ON THE
INTEREST RATE
 An increase in the income level

md1
Rate of Interest (r)

ms
md

r2

r1

m
CHANGES IN THE SPECULATIVE DEMAND
FOR MONEY AND THEIR EFFECTS ON
INTEREST RATE
 Based on wealth holder’s expectations regarding the
normal rate of interest
CRITICISM OF THE KEYNESIAN
APPROACH
 Keynes has denied influence of the real factors, saving
and investment in the determination of rate of interest.
This is a view too extreme.
 Keynes theory is indeterminate.